A history of corporate governance and why it remains so important

Learn more about the rich history of corporate governance and why it is still such a critical concern for businesses today.

By AnsaradaTue Sep 06 2022CEO-CFO

Origins of the concept of governance


The origin of the word governance goes back to Ancient Greece, where the word kubernaein meant to steer, in relation to a ship. Since then to “govern” has been applied to the control of peoples and latterly companies.

Corporate governance is a fairly recent issue, but the concept has been in existence as long as the corporation itself - really as long as there has been large-scale trade, reflecting the need for responsibility in the conduct of commercial activities.

British company law, which grew up in the nineteenth century, offered business the protection of limited liability by separating personal liability from that of corporate organizations. Personal liability could therefore be limited to the amount of the shareholding in a legally incorporated company. This worked well when the shareholders were truly proprietors, and it still obtains today, in medium and small businesses. Major companies, on the other hand, do not usually function like that any more.

The size of companies began to change as a result of the new technologies of the Industrial Revolution, which required much larger firms to create economies of scale.  Shareholders ceased to manage them directly and hired professional managers to run them instead. As time went on the managers began to graduate to board level, and gradually came to form the majority of board members. The process of completely separating ownership and control accelerated after the Second World War as financial institutions started to build up their industrial investment portfolios. The fund managers who handled these investments had no interest in individual shares as such. Their job was to balance their portfolios, which they did by diversifying them. They left the management of the companies to the professional managers.

The formal division between boards of directors and the business management continued into the second half of the 20th Century in many of the old industries like banking, insurance, shipping, brewing, construction, textiles and the larger manufacturing firms, where it was for a long time customary to separate the board from the executive management. The chief general manager was often the only member of management to attend board meetings, and even then not necessarily as a director. By the last quarter of the last century all these companies had changed their structures following takeovers, amalgamations and changes in social attitudes. In smaller organizations, of course, the executives, who may often be the owners, will usually constitute the majority of the board, and the issue of fiduciary duty to the owners doesn’t apply in the same way.

Corporate governance developed as a subject for academic research, probably mainly in the United States in the years after the Second World War, but it came to prominence in the UK with the publication of the Cadbury Report on the Financial Aspects of Corporate Governance in 1992. The title indicates the limited focus, which reflects the origins of the exercise which, prompted by recent corporate scandals, were all about protecting City investors from being exploited by rapacious managements who needed to be brought under a measure of control.

The Cadbury Code of Best Practice had four sections with 19 subsections and covered a mere two pages, but its principles, with the related mandate to “comply or explain” reasons for non-compliance, have since been largely adopted all around the world, with the exception of the United States. The simplicity of Cadbury has been lost to some extent in subsequent elaborations and the UK Corporate Governance Code as it is now known (most recently updated in 2018 following a comprehensive review), is a more substantial document, but the pragmatic approach of comply or explain is retained.

A survey of Codes of Corporate Governance round the world suggests that the UK’s approach is broadly the one that has been followed, even in the non-Anglophone countries which adhere to the two-tier board, compared with the UK’s preference for unitary boards.
 

Current definition of corporate governance


Since the production of Sir Adrian Cadbury’s seminal Report, most people turn to the definition by his Committee, which was:

“Corporate Governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the board include setting the company’s strategic aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship. The board’s actions are subject to laws, regulations and the shareholders in general meeting.”

Just over a decade later, in 2004, the OECD defined corporate governance as:

“Procedures and processes according to which an organization is directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organisation – such as the board, managers, shareholders and other stakeholders – and lays down the rules and procedures for decision making.”

In that period, we can see the emphasis broadening from the company-to-shareholder relationship of Cadbury to the more inclusive OECD definition which mentioned other stakeholders. Two years later, the UK Companies Act of 2006 addressed the general duties of directors in broader terms still, talking about promoting the success of the company for the benefit of a wide range of stakeholders.

Since then, the trend worldwide (with the possible exception of the USA until recently) has been in the direction of stakeholder inclusivity, and it is starting to be taken for granted that companies which demonstrate good corporate governance, defined broadly, perform better and demonstrate stronger value creation.
 

The importance of good corporate governance


The company is an independent entity, and the role of the Board of Directors is to look after the health of that independent entity. The Board’s role is NOT to run the company, which is the job of the management team appointed to fulfil that role. The tendency for the two roles to overlap is to be guarded against, hence, for example, the insistence on splitting the roles of Chair of the Board and CEO of the company. When a senior executive sits in the boardroom as a director, he or she performs a different role and has different responsibilities from those of their executive role.

Notwithstanding this, if board members don’t understand how a business really works, compliance with board behaviour rules won’t prevent bad results. It may seem obvious that directors should bring reasonable skills to board meetings and take proper account of the long-term future of the businesses for which they are responsible, but experience shows that even in the biggest companies, this cannot be taken for granted.  Sadly, time and again, corporate scandals suggest the boards of the companies concerned clearly were not paying attention to how their companies were being run.

To illustrate the huge financial impact of corporate governance gone bad, here in Figure 1 is a short list of some of the disasters of the past few years and the impact they had on each company’s value following the disclosures.

Figure 1: Nigel Kendall, Applied Corporate Governance

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The author, Nigel Kendall is a Chartered Accountant, Corporate Governance Consultant, and the author of several books on financial management and corporate governance. His first book gained him the endorsement of Sir Adrian Cadbury, the father of modern corporate governance. With a wide-ranging career history and over 20 years’ experience as an independent consultant, Nigel works regularly with boards of all-sizes of organisations on corporate governance, best boardroom practice and strategy.
Nigel Kendall, Corporate Governance Consultant, Applied Corporate Governance

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